Implications for hedging of the choice of driving process for one-factor Markov-functional models (Q2853380)

The problems of hedging Bermudan swaptions in the one-factor swap Markov-functional model is considered in this paper. The authors focus on the choices of the instantaneous volatility of the driving Markov process and discuss two possible parametrizations, by time and by expiry. The latter is exemplified by a mean-reversion process while the former is based on the Hull-White short-rate model. Then a new parametrization by time is proposed which takes as input into the model the market correlations of relevant swap rates. Its advantages are shown by computing the vegas of a Bermudan swaption, by providing a very effective vega-delta hedge, and by emphasizing the gamma risks. An analysis of the gamma-theta balance concludes the paper.